Financial advisors come in different shapes, sizes and compensation methods. Some will charge you directly for their advice, while some appear to be offering a free service since you never see any fees.
Rest assured, nobody works for free. It’s important to learn the different styles of compensation, so you can make an informed decision about which type you prefer. The compensation methods are not mutually exclusive, it’s possible to find advisors who offer every type listed below.
Front-end sales commissions on investment products
Some investments product provide a commission to your advisor as soon as you make the purchase. If you use a stock broker and make a trade, they will get a percent of the trade commissions. Mutual funds can have two types of commissions – front end or DSC (deferred sales charge).
Front end fees are a percentage of the transaction amount. For example if you buy $10,000 of mutual funds with a front end fee is 1.5%, your advisor will get $150 and the remaining $9,850 will go into your account.
DSC fees or back-end fees are paid to the advisor by the mutual fund company, so you never see them. For example; if you buy $10,000 of a DSC type mutual fund with a 5% commission, your advisor will receive $500 from the mutual fund company and your entire $10,000 will go into your account. Sounds like a great, right? The catch is that if you withdraw money from the fund company within a set period of time, you will pay a DSC redemption fee. Here is an article on why DSC fees are not so bad for smaller investors.
Investment products which offer a sales commission can encourage advisors to sell more investment products to the clients, regardless if the products are appropriate or not. For example, a retired person might be a good candidate to put some of their money in equities and some in an annuity. It would be more profitable for the advisor to recommend that the client put all their money into equity mutual funds, rather than allocate some of it to an annuity.
Ongoing trailer fee commissions
Another type of commissions that financial advisors can receive from mutual funds are called trailer fees. These are ongoing commissions paid to the advisor by the mutual fund itself, as long as you own the fund. They typically range from 0.25% to 1.0% per year. Trailer fees also encourage advisors to recommend clients to be invested in mutual funds rather than alternatives, such as annuities or using money to pay off debt.
Another problem with trailer feesis that equity-based mutual funds tend to pay a higher trailer fee commission than fixed-income funds which could lead to your advisor recommending a higher equity allocation because it is more profitable for the advisor. This is known as equity bias.
Commission as percentage of assets or regular scheduled dollar amount
This type of compensation is part of “wealth management” services and is usually reserved for clients with larger portfolios. The idea is that the advisor will manage the portfolio and charge a set percentage of the portfolio size – perhaps 1.0% per year. In this type of arrangement, the advisor will usually have the ability to change your asset allocation and buy and sell investments. The larger your portfolio is, the lower the annual fees as a percentage should be. A similar arrangement can occur when a company charges you a fixed dollar amount per month instead of a commission.
You need to shop around to make sure you get the best fit for the advisor as well as a good price. One of the big downsides of this type of plan is that the advisor may not do much once you are signed up. She will get the same amount of compensation whether she spends 30 minutes per month working on your account or 10 hours.
This type of compensation is known as fee-based. This type of advisor will charge for their service the same way a lawyer does – either by the hour or a set fee for certain tasks.
For example if you want an advisor to put together a comprehensive financial plan, they might charge $100 and work 10 hours for a total of $1,000. Or they might have pre-set packages so you can pick how much service you want for a pre-determined price.
This type of payment can be very useful, since you can hire the advisor when you need them. Most people do not need a comprehensive financial plan drawn up for them every year. Ideally one might pay more money for a financial plan and then just pay smaller amounts for subsequent annual or bi-annual checkups.
The downsides of this sort of arrangement are:
Too expensive for small accounts. Paying $1,000 for a financial plan when your portfolio is only $2,000, does not make any sense.
Possibly too much detail. If you are close to retirement, you want your advisor to spend lots of time analysing your finances because you need to make sure you’re on the right track. If you are younger, then your financial plan will likely be simpler and you should be paying less than someone who needs a more comprehensive financial plan.
The last compensation type is salary. This investment professional does not get commissions based on the investments they recommend to you. There could be a bonus based on volume of business.
This type of advisor can still be quite biased if their employer pressures them to sell certain in-house products. It is likely that the range of investment options can be smaller than a regular financial planner.
There are many different compensation models available to financial advisors. As an investor, it’s important to know how your advisor is being paid. There aren’t any good or bad payment methods – at the end of the day, it’s the total amount of fees that you are paying which really matters.
Do you know how your financial advisor is paid??